DIRECTOR : Enderstein Van der Merwe Inc. Law firm with offices in Cape Town & Johannesburg LL.B (University of Stellenbosch) Postgraduate Diploma in Financial Planning (University of Stellenbosch) B.Compt (Financial Accounting)(UNISA)* (in progress) wessel@endvdm.co.za (011) 615 8591
Understanding the tax implications that can make or break your returns on a property investment
Ensure highest possible Return on Investment ( ROI ) Net effect / more money in your pocket
Increase income / reduce expenses Tax is also an expense which has net effect on the bottom line of your ROI Goal is to reduce tax liability as much as possible How does one go about to reduce your tax liability?
Difference between the two definitions is the basis of legality. Tax avoidance is legally exploiting the tax system to reduce the current or future tax liabilities by means not intended by SARS or government. This often involves artificial transactions that are contrived to produce a tax advantage. Tax evasion is essentially the opposite to tax avoidance, being the nonpayment or underpayment of tax which is an illegal practice in South Africa and most other parts of taxpaying countries.
CGT was introduced in OCTOBER 2001 and is applicable to capital gains made after that date; Rules relating to CGT contained in the Eighth Schedule of the Income Tax Act. Also visit www.sars.gov.za for comprehensive notes on the subject, alternatively consult with your accountant and/or financial planner for professional assistance; CGT is not a separate tax, but falls under the collective umbrella of normal tax, along with the traditional income tax, and is merely one of many factors taken into consideration when determining an entity s or individuals taxable income; CGT is triggered / will only arise on the disposal or deemed disposal of a capital asset.
Property must be sold to trigger the effect of CGT. Disposal is extensively defined in the Eighth schedule of the Income Tax Act referred to earlier in the presentation, and even includes involuntary disposals such as the loss, destruction or expropriation of an asset. Once an asset has been sold, the proceeds from that asset must be determined; Once the proceeds have been determined, the next step is to establish whether a gain or a loss has been made from the sale of that asset.
A base cost is established / allocated to the asset in order to determine the net effect of the proceeds. If the proceeds are greater than the base cost, there is a capital gain. If the proceeds are less than the base costs, there is a capital loss. What amounts can be deducted from the proceeds / included in the base cost? All of the following amounts actually incurred as expenditure directly related to the acquisition, creation, variation or disposal of an asset may form part of the base cost of such asset: Acquisition costs Agent s commission Advertising costs to find buyer Valuation costs for the purposes of determining a capital gain or capital loss Transfer Costs Transfer Duty Costs of establishing, maintaining or defending a legal title to or right in the asset. Cost of effecting an improvement to or enhancement of the value of the asset, if that improvement or enhancement is still reflected in the state or nature of the asset at the time of its disposal. NB: Holding costs generally do not form part of the base cost of an asset. Thus, expenditure on repairs, maintenance, protection, insurance, rates & taxes or similar expenses is specifically excluded.
If there is a capital gain, it must then be determined whether or not there is an exclusion or roll-over from CGT. Not every disposal or deemed disposal will give rise to a taxable capital gain, as such gain may be excluded from CGT or a deferment / roll-over may be available. Examples of exclusions from CGT for investment property purposes: 1. Primary residence exclusion: First R2 million of capital gain is exempt from CGT (NB: Only a natural person or special trust can be considered to be in possession of a primary residence. Not applicable to trusts & companies) Primary residence A residence in which a special trust or natural person has an interest in and that person, trust beneficiary or spouse ordinarily resides in same as their main residence, and uses it mainly for domestic purposes. 2. ANNUAL EXCLUSION OF CGT: INDIVIDUAL R40 000.00 YEAR OF DEATH R300 000.00 Examples of roll-overs from CGT for investment property purposes: 1. The involuntary disposal of an asset (destruction or loss), and the proceeds exceeds the base cost of the asset 2. Transfer of an asset to a spouse (either through donation or bequest), or a transfer of an asset to a former spouse following a divorce agreement or settlement.
At the end of the tax year, all taxable capital gains must be taken into account, as well as all capital losses. The capital gains are then offset against the capital losses, with the end result being either a net gain or a net loss. If a net capital gain exists, a percentage of that gain (either 40% or 80%) is included in the taxpayers taxable income. EFFECTIVE RATES OF CGT Individuals & Special Trusts - 40% Ordinary Trusts - 80% Companies - 80% If there is a net capital loss, that loss is not included in a taxpayers taxable income. It may however be carried forward to the next tax year and used to offset any capital gains that may arise in future.
Example: NATURAL PERSON OR SPECIAL TRUST An asset was sold, and a capital gain (not profit) of R100.00 was achieved on the sale of that assets. We assume that seller falls in the top tax bracket of 45%. Thus: 40% of the capital gain is taxable. 40% of R100 = R40.00 The R40 is then taxed in terms of the top tax bracket of 45% 45% of R40.00 = R18.00 Accordingly, the maximum effective rate = 18%
Example: COMPANY Same example applicable as with natural person, but applied on the basis that seller is a company or close corporation. Thus: 80% of the capital gain is taxable. 80% of R100.00 = R80.00 The R80.00 is taxed in terms of the company rate of tax of 28% 28% of R80.00 = R22.40 Accordingly, the maximum effective rate = 22.40%
Example: REGULAR TRUST Same example as with natural person and companies, but applied on the basis that the seller is a regular trust. Thus: 80% of the capital gain is taxable. 80% of R100.00 = R80.00 The R80.00 is accordingly taxed in terms of the trust tax rate of 45% 45% of R80.00 = R36.00 Accordingly, the maximum effective rate = 36%
From the examples presented, it should be clear that from a CGT perspective, the sale of a property by a natural person or special trust incurs the smallest CGT liability of all holding options. However, CGT is one of many factors that must be taken into consideration when making a decision as to the investment vehicle / holding entity you wish to utilise when buying property.
SECTION 13sex OF THE INCOME TAX ACT
Section 13sex allows for a developer to write off the cost of all new and unused residential units that they erect after 21 October 2008 at a rate of 5% per annum. This write-off also applies to the cost of new and unused improvements to existing buildings.
A purchaser of residential units is also entitled to claim the allowance in terms of 13sex, but it is limited to a total of 55% of the price they paid for the unit. In summary if you are not the developer of the unit but you purchased the property directly from the developer, you are still entitled to claim the allowance.
Where the cost of a unit is R350 000.00 or less (and the monthly rental charged on the unit does not exceed more than 1% of the cost), the incentive increases to 10%. The 10% allowance may also be claimed in instances where the cost of a standalone unit is R300 000.00 or less, the owner does not charge rental of more than 1% of the cost and a proportionate share of the cost of the land and the bulk infrastructure. These are referred to as low-cost residential units.
1. The unit must be new / unused and must be predominantly used for residential purposes. 2. The unit must be used solely for the trade of the purchaser / taxpayer. The purchaser / tax payer may accordingly not make personal use of the unit. 3. The purchaser / taxpayer must own at least five residential units within the Republic of South Africa before qualifying for the allowance, and all of the units must be used for the taxpayer s trade. 4. The units for which an allowance is claimed must be situated within the Republic of South Africa.
The amount of the allowance / deduction is limited to the lesser of the actual cost or the market value. Purpose? To prevent tax evasion by allowing taxpayers to inflate the price with the goal of claiming a higher deduction / allowance. No allowance is permitted where a taxpayer claimed for the same property under another section of the Income Tax Act. Sale proceeds will be subject to normal income tax (CGT) to the extent that allowances were claimed under section 13sex
No such thing as a free lunch. SARS does not hand out tax rebates, deductions or monetary benefits for the sake of being generous; Buyers / investors are warned to keep in mind that such a deduction would only be available for as long as the purchaser / taxpayer owns the units and earn rental on it. Once the units are sold, there would be a recovery of the tax allowance received in prior years in the form of capital gains tax and same would be levied against the proceeds. It is accordingly nothing more than a temporary tax incentive. Tax should not be primary driver of investment, must make commercial sense Dr Beric Croome (Tax Executive ENS Africa)
Any rental income received by a natural person, trust or company is considered to be taxable income, and as such is subject to being taxed. The taxable amount derived from the rental income may be reduced as you may incur expenses during the period that the property was let. Only expenses incurred in the production of rental income can be claimed. Capital and/or private expenses will not be allowed as a deduction.
Expenses that may be deducted from taxable income include: Rates & taxes Bond Interest (Very important!) Advertisements Agency fees of estate agents Insurance (only homeowners; not household contents) Garden services Security and property levies Repairs in respect of the area let
Bond Interest A lot of purchasers forget that the monthly interest that they pay on their mortgage bond is deductible for income tax purposes and can work to their benefit. Example: Client owns a property financed through Bank X at the prime interest rate of 10.5% Client falls in the 30% income tax bracket The effective rate of interest that client then pays on the mortgage bond is approximately 7.35% It is accordingly not in the interest of the owner to settle the mortgage bond as soon as practically possible, as the full rental income received every annum will be taxable.
Tip: Request your financing institution to register a mortgage bond on the property that is larger than the original amount financed. Reason? : Should you wish to apply for a future loan against the asset (on the assumption that the value of the asset has increased since the original loan), the financing institution would then not need to register a second mortgage bond over the property, which is a saving on acquisition costs. These extra funds can then be utilized for the purchase of a second property (NCA / affordability)
Expenses which may NOT be deducted from taxable income include: Improvement / enhancement costs (will only derive benefit of this expense when determining the base cost of the asset when same is sold and CGT is applicable) When it comes to VAT expense claims, the supply of a dwelling is an exempt supply for VAT purposes, and as such you cannot deduct VAT incurred on its expenses.
What if the expenses exceed the rental income? In such an event, the loss should be available to be off-set against other income earned by the homeowner, provided that losses are not ring-fenced in terms of prevailing anti-avoidance provisions. The homeowner must effectively be able to satisfy SARS that he is carrying on a bona fide trade through the rental of his property.
Trusts are an investment vehicle predominantly utilised for estate planning purposes. It is a very popular tool used by financial planners for a variety of reasons.
ADVANTAGES OF A TRUST Estate Freezing - A client can for example sell growth assets (such as immovable property) to a trust, and any increase in the value of that asset will be excluded from any CGT that can arise on death, and will also be excluded from a client s dutiable estate for estate duty purposes, because the growth takes place in a trust. Asset protection, including protection against creditors especially important for people who have exposure to potential liability for claims arising from their business activities. Beneficiaries can enjoy the fruits of assets owned by the trust, whilst not owning the asset themselves, thus prohibiting creditors from executing against the assets. (Terms and conditions apply impeachable transactions). Exposure to creditors loan accounts. Efficient succession for future generations easy succession of interests in property. If beneficiary dies, there will be little or no impact on future enjoyment of trust assets. Protect an heir from bad marriages, creditors or bad business decisions. Trusts allows for flexibility to effect distribution of assets if required in the future. Multiple owners of assets One owner (trust), multiple beneficiaries, as opposed to multiple owners of one property.
DISADVANTAGES OF A TRUST Costs Costs of transferring assets to a trust can be prohibitive. Transfer duty will be applicable if property is transferred from natural person to trust, and as such it is imperative that correct structure is set up from the get-go in order to ensure there is no double payment of transfer duty. Duties of Trustees Very onerous. Trustee can still be held personally liable if he/she does not act with a reasonable degree of care, diligence and skill. Control In order for the trust to be truly effective, the founder of the trust must be willing to give up control of the assets, as any action to the contrary will defeat the very purpose of the trust. Such action could however have dire consequences on the death of the founder, as the assets could be deemed to be that of the founder, thus nullifying any benefits one would have hoped to obtain by retaining the assets in a trust. Higher tax bracket -Trusts are taxed on a much higher bracket and at a flat rate of 45%, as opposed to natural persons who are taxed on a sliding scale of between 18% - 45%, depending on the total amount of taxable income received.
Recent Developments Section 7C of the Income Tax Act In an effort to curb avoidance of tax by utilising trusts, section 7 of the Income Tax Act provides new anti-avoidance measures. Came into operation 1 March 2017 Previous position : Properties transferred to a trust / Loan Account / Donation Tax (R100k p.a) Section 7C applies where a loan is made available to a trust, no interest is payable on the loan, alternatively interest is payable at a rate lower than the official rate of interest contemplated in the Seventh Schedule to the Income Tax Act (currently 8%), and the loan is made available to the trust by a natural person or a company that is a connected person in relation to that natural person Effect : 1. No deduction, loss, allowance or capital loss may be claimed in respect of a disposal, including by way of a reduction or waiver, or in respect of the failure to claim payment of any loan, advance or credit referred to above. 2. If a loan is made to the trust interest-free or at a rate lower than the official rate of interest as defined in paragraph 1 of the Seventh Schedule to the Act (Official Interest Rate) (the rate is currently 8%), an amount equal to the difference between the interest charged by the lender or holder of the loan and the Official Interest Rate will be treated as a donation made to the trust by the lender or holder of the loan.
Conclusion A lot of individuals immediately jump at the opportunity of creating a trust for wealth creation or -preservation purposes, but fail however to fully utilise all the tax benefits they may have enjoyed in the event that the asset was purchased in their personal capacity.
Conclusion Tax savings should never be the main and sole purpose for the creation of a trust. To make decisions about the assets in a trust based purely on tax implications would be ill-advised. The protection a trust offers assets of an individual remains its biggest benefit. Not only does it protect against creditors, but also against family members who are unwilling or unable to manage the assets responsibly or effectively. In addition, a trust ensures continuity and continues irrespective of death. This allows it to continue supporting beneficiaries when an estate or assets of the deceased are frozen pending the finalisation of the estate. When deciding how to handle loans to a trust, these aspects must also be considered.